In recent years, regulation of the securities industry has increased in an effort to protect investors and hold brokers and firms accountable to the public. The Financial Industry Regulation Authority, or FINRA, has taken a primary role in creating rules to regulate the securities industry, and enforcing violations of these rules. One of FINRA's goals is to protect consumers from risky or abusive behavior by brokers. In furtherance of this goal, FINRA created a rule requiring that brokers have a reasonable basis to believe that a certain investment strategy is "suitable" for a particular customer. Read on to learn more about suitability and FINRA Rule 2111.
What Is FINRA?
The Financial Industry Regulation Authority (FINRA) is a non-governmental, not-for-profit organization authorized by Congress. FINRA is a self-regulatory organization (SRO), and its goal is to protect investors by ensuring that the brokerage and securities industry operates fairly and with integrity. The Securities Exchange Act of 1934 originally created SROs to enforce industry standards and requirements for securities trading and brokerage.
FINRA is the successor to the National Association of Securities Dealers, which served as the member regulation, enforcement, and arbitration operator for the New York Stock Exchange. Members of FINRA include all securities firms that do business with the public. FINRA also provides oversight and enforcement to the New York Stock Exchange, NASDAQ, MSRB, the American Stock Exchange, and the International Securities Exchange.
FINRA's major objectives are to oversee licensing of individuals and firms in the securities industry, provide education and qualification exams for securities industry professionals, draft rules to govern industry behavior, examine broker behavior for regulatory compliance, and discipline members that fail to comply with federal securities laws and FINRA's regulations. FINRA also maintains the Central Registration Depository, which is a database of all registered individuals and firms. FINRA is subject to the oversight of the Securities and Exchange Commission.
Suitability and FINRA Rule 2111
FINRA has a variety of rules governing brokers and firms. FINRA Rule 2111 requires that a broker have a "reasonable basis" to believe that a recommended transaction or investment strategy is "suitable for the customer" based on facts obtained through "reasonable diligence." This rule is aimed at remedying past abuses and "yield-chasing" behavior in brokers at a client's expense.
Essentially, Rule 2111 places three explicit obligations on brokers:
Reasonable Basis Obligation
Under FINRA Rule 2111, a broker must have a "reasonable basis" for believing that a recommended course of action is suitable for a particular customer. To meet this obligation, brokers must:
What constitutes a reasonable basis will vary depending on the circumstances. However, a broker would violate this rule if she recommended a strategy without first thoroughly understanding the particular strategy herself. In recent years, securities and investment strategies have become increasingly complex. It’s essential that brokers fully understand any recommended strategy, or they risk running afoul of FINRA's suitability requirement.
Expanded Customer-Specific Factors
FINRA Rule 211 also places an obligation on brokers to learn as much as possible about a customer before recommending any course of action or investment strategy. In fact, Rule 2111 expanded the list of customer-specific factors that a broker must analyze, including a client's:
Brokers must use reasonable diligence to gather as much information about a customer's investment profile before making any recommendations. The onus is placed on the broker to ask relevant questions, not on the client to volunteer information.
The requirement for quantitative suitability included in FINRA Rule 2111 is actually a codification of already existing excessive trading cases. Since brokers often receive a fee for any transactions they make on their clients’ behalf, they may be tempted to make unnecessary transactions. However, excessive trading by a broker to boost her own commission at a client's expense is unethical. For this reason, Rule 2111 requires that brokers have a reasonable belief that a series of transactions, even if suitable when viewed in isolation, do not become unsuitable when taken together.
Get Legal Help with FINRA Rules
Whether you're a broker or an investor, it's important to understand FINRA's rules about suitability so you can make informed decisions and fully protect yourself and your investments. If you have questions about FINRA, consider getting legal help by conferring with an experienced securities lawyer.
Contact a securities lawyer to assist with any issues related to securities laws and financial instruments.